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It seems that, collectively, we have identified some challenges to the milestone concept for litigation funding – at least in the market as it currently operates.

First, we seem to agree that the litigation funding market today is quite thin. Neither claimants nor funders therefore, cannot assume that other investors will be available to carry on funding in the event that the funder chooses to drop out at a milestone. That contrasts with the VC market where there are many players who look to invest in viable business concepts at various stages of a company’s development.

Your point that anticipated litigation values do not fluctuate materially during the course of the case is also well taken. It reflects the fact that, in a well underwritten case, the liability should be fairly evident and the recovery should be within the range of measurable damages going into the case. Accordingly for a litigation funder, the expectation is that, by funding the case to resolution, there is a strong likelihood of a recovery in an amount that is within a reasonably predictable range.

That contrasts with venture capital where there is an investment thesis with enormous potential returns but a great deal of market risk and execution risk which must be navigated to achieve value. In the VC context, outcomes are much less predictable and generally binary – either a great sucess or a complete loss. In that volatile investment environment, the periodic review of valuation and investment thesis is essential. Moreover, among the universe of VC investors there are many viewpoints on the potential and value of emerging businesses.

Accordingly, a litigation funder operates in an environment where there are few, if any co-investors with whom to share and transfer risk, but a fairly predictable and stable asset in which to invest. As a result, a prudent funder will have to enter into the transaction fully expecting to have to fund the case to completion but also fully expecting a fairly predictable dollar recovery. Similarly and as Maya’s note indicates, the claimant has a very strong incentive to avoid running out of funding prior to completion of the case. Accordingly, in today’s market both parties’ interests are aligned to make sure at the outset that there is adequate funding to see the case through to conclusion. As aresult, I am now sceptical that either the funder or the claimant will benefit, in the current environment, from commencing litigation with funding only to the next milestone.

Therefore, it is my view that today funders have to underwrite and commit to the entire case up front. Typically the underwriting process will start by developing a point of view on the merits of the claim to determine whether the funder has threshold interest in funding the case. If that hurdle is crossed, the funder needs to determine how to price the transaction to achieve a financial return commensurate with the risk. To develop a pricing model, the funder has to evaluate the realistic recovery value of the case, the duration of the case completion and the amount that the funder will need to invest to support the prosecution. While the recovery and duration are predictable but also largely influenced by external forces, the budget (assuming consideration of adequate contingencies) is most susceptible to management by the claimant, its lawyer and the funder.

Naturally therefore, the funder will require that the claimant and its attorney provide a budget for the prosecution of the entire case with provision for all of the potential contingencies – anticipated delays and motion practice by the defendant, interim appeals, etc. – in order to underwrite the case in conjunction with the funder’s view of recovery value and duration. The funder, with the full knowledge of the claimant and its counsel, will rely upon that budget in negotiating the terms of the investment. The key terms being the amount of the anticipated recovery that the funder will receive for its commitment to fund the case and, because the funder cannot accept the risk of inadequate funding or an open-ended commitment, the maximum amount that the funder is prepared to advance toward the prosecution of the case.

That brings us to the question of which party should bear the risk of budget overruns. Because a funder cannot properly price its investment with an open ended funding risk or inadequate funding to complete the case, there will have to be an agreement in the investment contract allocating the responsibility to fund budget overruns among the claimant, its counsel and the funder. The options are that the claimant can fund some or all of the overruns, counsel can agree to either defer some of its fees in exchange for interests in the recovery or take a write off for the overrun or the funder can agree to provide additional funding possibly in exchange for more of the recovery.

As I indicated in my first comment, it is difficult to imagine a scenario in which the funder causes the cost overrun. My view, therefore, is that as a general rule the funder should not be expected to fund the overrun.

One situation to consider is where the claimant and its counsel affirmatively make a strategic decision to spend more money on expert witnesses for example. In that case, they can proceed unilaterally and elect to fund the cost themselves or to involve the funder in the strategic decision in order to convince the funder of the benefits of providing the additional funding. Another scenario is where the overrun arises from counsel’s failure to manage the case or failure to budget for the contingencies in the case. In those cases it would be most appropriate for counsel to bear the cost through deferral or write off.

I agree that Professor Rhee’s suggestion of a time based anti-dilution provision to deal with unexpected delays is a very good one that will align interests and improve pricing to the claimant.

Finally, I believe that allocating the uncertainty of the litigation cost to the claimant and/or its counsel will promote better pricing to the claimants by eliminating an open-ended element of risk that the funder would otherwise have to charge for.

2 thoughts on “Milestones: A Response”

When compared with the outcomes of venture capital investments, sucessful outcomes from litigation funding investments are relatively predictable and outcomes are within an identifiable range.

The venture capital portfolio typically consists of many failures and a small number of very big winners. In a recent FastMoney article, Harvard Business School lecturerer Shikar Ghosh reports that 75% of venture backed companies do not return money to their investors based on a survey of more than 2000 venture backed companies. Our observation and the published results of the publically traded companies that finance large commercial litigation cases demonstrate that the percentage of sucessful outcomes on litigation investments is in the range of 75% to 80% of cases funded. Much higher than in the venture capital world. In addition, IMF’s results have clearly demonstrated that by monitoring the progress of the case and exercising withdrawal rights in those cases where adverse developments occur, the losses in those cases can be controlled. Specifically, as of June 30, 2012, IMF reported that out of 137 completed cases, 32 cases with adverse results and IMF withdrew from 27 of those cases with an average cost per withdrawn case of about $70,000. IMF only lost 5 of the 137 cases at trial.

Similarly, while venture investments have the potential to achieve Facebook sized valuations, the recoveries from litigation are typically bounded by the high and low end of a range of provable damages. In that sense the outcomes of litigation are relatively predictable.

At Themis, we manage the risk that the plaintiff will run out of funding by establishing budgets for each phase of the case and allocating portions of our aggregate funding commitment to each phase. Accordingly, if there is a cost overrun at the discovery stage, there is still funding allocated to, and available for, the pre-trial, trial and post-trial phases. We also require that the engagement letter between the plaintiff and its counsel addresses which party will bear the risk of cost overruns and how they will be financed as a condition to our financing.

Ed: Themis, obviously, has a different model than my company, Lawsuit Financial. However, the concepts and considerations are very much the same. I don’t know if I can agree with your statement that “litigation values do not fluctuate materially during the course of the case”. I have found, in 36 years of combined legal and legal funding experience, that there are so many intangibles in litigation and so much can happen with evidence and discovery (the milestone model assumes pre-discovery, case inception, funding, doesn’t it?) that even excellent underwriting sometimes can’t prevent substandard litigation results. I don’t agree that a litigation funder can expect a “strong likelihood of a recovery in an amount that is within a reasonably predictable range”; there are just too many intangibles throughout the course of ANY litigation. That is why the cost of litigation funding has, historically, trended on the very expensive side. There is also a “Catch-22″ element for the funder. Once he/she is heavily invested in the case and “overruns” are necessary to attempt to secure a successful conclusion, what choice does the funder have other than to continue to fund? I like your idea that “budget overruns” be assumed by law firm and/or litigant, but what happens when neither can assume them (although, plaintiff and/or law firm financial strength to do so is something that a funder can underwrite with predicability)? Perhaps an “overrun escrow” could be established at the time of funding or an upfront fee deference agreement could be arranged. While allocating “the uncertainty of litigation cost to the claimant and/or its counsel” sounds like a fair way to keep the cost of litigation funding down, the “Catch-22″ scenario may rear its ugly head. Counsel and/or claimant says: “We can’t proceed with this litigation unless and until we get more money”. Funder already has a substantial investment in the case and sees its money going down the drain. What does the funder do?